A new study from The University of Texas at Dallas have found that companies base upon a CEO’s personality trait for compensation contracts and incentive pay. It turns out that overconfident CEOs get paid more.
The study published in March in the Journal of Financial Economics explains that overconfident CEOs tend to believe that the company is going to do well so he asks for more money in his contract. They overestimate returns to investments but underestimate the risks and use positive words that will boost the ego of the company’s board.
“When you think about incentive contracts, you don’t usually think about the personality of the individual being a factor in the contract,” says Vikram Nanda, O.P. Jindal Distinguished Chair of finance and managerial economics in the Naveen Jindal School of Management. “You don’t usually hear about how two profit-sharing agreements are going to look different because the personalities and the beliefs of the individuals are coming into play.”
“Are CEOs being given these contracts because they are serving an incentive function — incentive contracts are supposed to say you’ll get paid more if you do the right thing or work really hard — or are they just being paid more because these CEOs value these contracts more?” Nanda adds. “If a CEO believes the firm is going to do very well, maybe he will take a lot of his compensation in options and stock.”
The researchers analysed the compensation data of CEOs between 1992 through 2011. They found that overconfident CEOs increased their proportions of total compensation from grants, equity grants. Even at the same firm, managers with different beliefs won’t get the same contract.
Moreover, overconfident CEOs got greater option and equity intensity in risky companies. Even those non-CEO executives received higher equity just because they were overconfident.
“It’s good to have your enthusiasm and your confidence,” Nanda asserts. “The question is if it’s too strong, is there something the firm can do — such as giving you incentive contracts, or monitoring your behaviour, or constricting what you can do — to bring out the good side and constrain the bad aspects?”